What will RBI do on April 5?

While RBI may go for a 25bps rate cut, the possibility of further cuts is not ruled out

Bond yields have rallied significantly in the last few weeks. This reflects endorsement of the Budget where the government signalled fiscal rectitude with its 3.5% fiscal deficit target for FY17, weak data from the real economy (a lower-than-expected industrial production print, minus 1.5% year-on-year, in January) and a better-than-anticipated CPI inflation out-turn for the month of February (5.2% versus consensus expectation of 5.5%), culminating in expectation of a larger than 25bps expected rate cut in the upcoming monetary policy on April 5. We, however, think there is only limited room for optimism.

Arguments for deeper rate cuts
* It can be argued that since the central government has adhered to the fiscal consolidation agenda, which will consequently not add any further fiscal impulse to the economy, consequently the central bank could use its monetary policy lever a bit more generously.
* Monetary transmission in India is typically weak and delayed due to a variety of factors. RBI has cut the policy rate by 125bps, but banks have reduced their lending rates on an average by only 60-70bps. Deeper rate cuts can help expedite transmission to bank lending rates.
* Despite the 7%-plus GDP numbers reported in the national accounts data, growth momentum on the ground remains weak, evidenced from the recent trend of various high frequency macro indicators. The economy will, therefore, surely benefit from lower cost of funds.
* Considering the malaise in the corporate sector, lower rates could make it marginally easier for the highly leveraged corporates to service their debt.

Arguments against deeper rate cuts
* Global commodity prices are showing signs of bottoming; indeed, Indian oil marketing companies have raised gasoline and diesel prices recently. This could mark the end of a year-and-a-half long disinflationary phase for commodity prices.
* The risk of food price spikes will continue to be a concern for the central bank. There is ample evidence of the asymmetrical impact of summer monsoon on food prices in the past—a bad monsoon definitely impacts food prices adversely, but a normal monsoon may not be a sufficient condition to put a lid on food prices—and this phenomenon will likely make RBI err on the side of caution.
* Core CPI inflation remains sticky at 5.5%, even under a weak growth environment. In fact, risks are that core prices, which essentially include various components of services along with housing, clothing, bedding and footwear, start to rise along with improvement in growth momentum. The implementation of the Seventh Pay Commission awards is likely to complicate matters further. The increase in the HRA component, as and when it happens, will likely increase housing inflation by an additional 30-50bps.
* Inflation expectation of households has likely bottomed according to the RBI survey and has inched up towards 10% since the last two quarters.

We think RBI will cut the policy rate by 25bps on April 5. We don’t expect the central bank to explicitly state that this is the last rate cut in this cycle, but provide guidance that further accommodation could be entertained if inflation pressures remain at bay.

There is some market chatter about a possible CRR cut, in the context of the need to reduce the liquidity deficit in the money market and expedite monetary policy transmission, but we note that this expectation is a persistent feature before each policy meeting, with RBI having disappointed each time, underplaying the importance of a CRR cut in driving lending rates lower. In our view, even if RBI cuts the CRR by 50bps this time, this will be just a one-off, as the CRR rate is already at a historical low, and we don’t think RBI will want to drive the rate further lower. We have more conviction in the fact that RBI will likely continue to do OMO purchases regularly in the next fiscal, in an effort to provide liquidity to the money markets.

While we think RBI will cut the policy rate by only 25bps in the upcoming monetary policy, we, however, do not completely rule out the possibility of further rate cuts in the second half of this year. Growth may continue to surprise to the downside, and if inflation stays at the 5% level, then the central bank may entertain a slightly lower real interest rate of 1-1.5%, as opposed to 1.5-2%, which might open up room for a further 25-50bps rate cut.